Market Outlook: Important Indicator Could Signal a Market Decline in 2014

October 14, 2013

Last week saw two big down days and two big up days. That pattern could repeat as markets react to rumors and news from Washington.

Rumors Increase the Number of Price Swings

SPDR S&P 500 (SPY) ended the week up 0.81% after big gains on Thursday and Friday reversed the losses seen in the first two days of the week.

Speculation about the government shutdown could be driving the market's short-term trading action, but in the long term, it will be earnings that determine whether stocks move higher or lower. As earnings reports come in, analysts will be watching operating margins. A week ago, analysts at S&P expected the operating margin of companies in the S&P 500 to set a new record.

Operating margins are a measure of profitability. They reveal how much of each dollar of revenue is left over after a company meets the costs of goods sold and operating expenses associated with running the company.

Economic theory holds that margins are mean-reverting, which means they move around a long-term average, and when they get too high, they fall back toward the average.

Logically, economists argue that when profit margins are high in one sector, competitors will notice the chance to earn large profits and move into that sector. Their entry will increase the supply of goods or services in that sector, and that should lead to lower prices, which result in lower margins.

At that time, companies leave the sector in pursuit of higher profits elsewhere, and the companies that remain in the sector are able to increase prices, which results in higher margins. This cycle repeats but moves slowly since businesses need time to move into new sectors.

If economic theory is correct, after reaching a new record, we would expect to see operating margins decline over time. And that might already be happening. In the past week, analysts have lowered their expectations and are now looking for operating margins to come in just below the record that was set in the third quarter of 2006.

The contraction and expansion of operating margins is a slow process. This, however, is an important indicator to watch. If margins are disappointing, that could be a sign that the pace of earnings growth is almost certainly slowing, and that would point to a stock market decline in the first quarter of 2014.

Before that happens, I expect to see stock prices continue moving higher into the end of the year. It is early in earnings season, but consumer discretionary stocks have been the strongest sector with 78% of companies beating estimates so far. The sector is also a relative strength leader, and leading names include Comcast (CMCSA), Ford (NYSE: F) and Starbucks (SBUX). The Consumer Discretionary Select Sector SPDR (XLY) is also a possible trading opportunity.

Gold Is Oversold but Not a Buy

SPDR Gold Shares (GLD) fell 3.11% last week, ending with a one-day drop of 1.34% on Friday. GLD is now oversold with a two-day Relative Strength Index (RSI) of 3.

GLD Market Outlook Chart
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GLD Market Outlook Chart

RSI(2) is a short-term trading tool. It uses only two days of data instead of the traditional 14 days to calculate the indicator. In the past, when RSI(2) has been this low, GLD has been higher 66.7% of the time one week later. However, the average losing trade has been significantly larger than the average winning trade, and over the entire trading history of GLD, traders would have lost money buying when GLD was this oversold. In the next week, additional losses are just as likely as a rebound in price, and short-term traders should stay on the sidelines.

The government shutdown is impacting gold trading. The Commodity Futures Trading Commission will not be issuing Commitment of Traders (COT) reports until the government reopens.

Traders rely on this report to understand who is buying and selling in the futures market. Without COT data, there is no way to determine if last week's decline was driven by the selling of large hedge funds or by commercials using the market as a hedge. This is one of the few reports that futures traders review, and until the data is updated, gold and other futures markets may experience increased volatility.

This Week's News

Government economic reports are still on hold, but traders will have earnings reports to consider every day this week, along with reports from private sources and from around the world.

Market Outlook News
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Market Outlook News

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